Throwing Good Money After Bad

Matthew Ryan (), Rhema Vaithianathan and Luca Rigotti
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Matthew Ryan: Department of Economics, Faculty of Business and Law, Auckland University of Technology
Rhema Vaithianathan: Department of Economics, Faculty of Business and Law, Auckland University of Technology

No 2014-01, Working Papers from Auckland University of Technology, Department of Economics

Abstract: An "investment bubble" is a period of "excessive, and predictably unprofitable, investment" (DeMarzo, Kaniel and Kremer, 2007, p.737). Such bubbles most often accompany the arrival of some new technology, such as the tech stock boom and bust of the late 1990's and early 2000's. We provide a rational explanation for investment bubbles based on the dynamics of learning in highly uncertain environments. Objective information about the earnings potential of a new technology gives rise to a set of priors, or a belief function. A generalised form of Bayes' Rule is used to update this set of priors using earnings data from the new economy. In each period, agents - who are heterogeneous in their tolerance for ambiguity - make optimal occupational choices, with wages in the new economy set to clear the labour market. A preponderance of bad news about the new technology may nevertheless give rise to increasing firm formation around this technology, at least initially. To a frequentist outside observer, the pattern of adoption appears as an investment bubble.

Keywords: Ambiguity; Belief Function; Investment Bubble; Inference (search for similar items in EconPapers)
JEL-codes: D51 D81 D83 J24 O31 (search for similar items in EconPapers)
Pages: 25 pages
Date: 2014-01
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Journal Article: Throwing good money after bad (2016)
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